Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 10 November 2015

More on UK interest and exchange rates

A lot of stuff written on UK interest rates reasons as follows. Many estimates of the UK’s output gap - the difference between actual output and the level of output that is consistent with steady (domestically generated) inflation - suggest it is almost zero. That cannot be consistent with nominal short term interest rates as low as 0.5%. Therefore a rise in interest rates is long overdue.

This ignores the rest of the world. Although the OECD estimate that the UK output gap in 2015 is zero, they also estimate it is nearly -2% for the OECD as a whole and nearly 3% for the Euro area. That means the UK is selling less goods abroad. For the UK output gap to be zero, we therefore need some other element of UK aggregate demand to take up the slack created by low exports. It is not government spending, which is going in the opposite direction. So it is consumers and firms that have to be encouraged to borrow more and save less. To put it another way, they need to be encouraged to shift spending from the future to the present. That means lower than normal UK real interest rates.

It is still true that monetary policy should be easier in the Eurozone than in the UK, but with active QE it already is. The fact that markets expect UK interest rates to rise well before those in the Eurozone intensifies the exports problem, because it means that exports are being hit not just by low demand but also by becoming less competitive as sterling appreciates against the Euro. [1]

The problem of low demand for UK exports would be made worse still if, as I suspect, sterling is overvalued even after you allow for differences in expected interest rates. Philip Lane, soon to become governor of the Irish central bank, has produced an interesting analysis of the recent deterioration in the UK current account. He concludes that “financial engineering may have played some role”. I suspect he is right, mainly because he is a renowned expert on these matters. However I wanted to stress that my arguments about overvaluation owed nothing to this recent deterioration.

The UK’s trade balance deficit has remained large and fairly constant for many years, despite the depreciation around 2008. That was not offset by investment income, even before the recent deterioration, which is why we have been running current account deficits for over 15 years. There may be good reasons why some countries run deficits for a long period of time, but it is not obvious whether any of these reasons apply to the UK, and those deficits in themselves mean that the equilibrium exchange rate will be depreciating alongside those deficits.

So we should not expect UK real interest rates to return to their ‘normal’ level until output gaps are closed in the rest of the world. We should also note that the Bank thinks that the normal or natural level of real interest rates is much less than it has been in the past (secular stagnation). Finally with inflation currently low, low real interest rates imply low nominal rates. All this would be true even if you were certain that the current UK output gap was zero, which I am not.

[1] Using UIP, the current real exchange rate is determined by the medium term equilibrium rate (calculated at zero output gaps everywhere) plus expected real interest rate differentials.


  1. True. And a lot of the problem here might be the Americanisation of macro, where you can put less emphasis on exchange rates, because it's a large open economy.

    But even if we do ignore the rest of the world (closed economy), the argument that "output and inflation are both normal again, therefore we must normalise interest rates too" is so wrong. And I've heard the same argument over here too. And not just from people who don't know economics. Had a devil of a job explaining to people what the BoC meant when they said that the new normal might be lower than the old normal.

    The natural rate of interest is not fixed in stone. The "normal" interest rate changes over time. A Taylor Rule with a fixed intercept is not a good policy.

  2. This is a good point, and I think applies to the U.S. as well. Also, I would include China as one of the deflation exporters here.

  3. Hi Simon
    What did you think of Andrew Sentance's four economic arguments for raising UK interest rates, due to the problems/dangers of the currently dangerously low interest rates as summarised below:
    1. The effect on the UK housing market and creating assett bubbles.
    2. The incentive for individuals to save (lack of), and impact on younger generations (saving for retirement), and the constraint on productive investment due to a lack of saving in the economy.
    3.Threat to confidence and "the Bank of England appears to be backing away from difficult decisions (to raise rates), its credibility risks being eroded."
    4. The first interest rate rise after the financial crisis is likely to be a bigger shock, the longer it is delayed. So raise now to minimise the shock!

    No mention of the output gap.


    1. On (1), if there is a problem use macroprudential tools - as the Bank (and its Financial Policy Committee) are doing. (2): there is no evidence of a shortage of savings holding back investment. (3) assumes Sentance is right! (4) Logic has completely left the room on this one.

  4. 3% output gap in the Eurozone ? according to the ECB / EU own estimates maybe; which are wildly undervalued as Bruxelles and Frankfurt try to avoid recognizing how badly the Eurocrisis was "managed". Try 10% AT LEAST. Eurozone current per capita GDP is 10%+ below UK / US cumulated trend from 1999 onwards.

  5. Why do you think that the output gap in the rest of the world makes much of a quantitative difference to the optimal interest rate? The references in Gali's textbook suggest that optimal policy in an open economy and a closed economy barely differ. Do you have another (possibly more recent) reference which you're basing this on?

    1. Why don't you try finding out why Gali's reasoning appears to be different, by looking at his analysis.

    2. I am not arguing that the reasoning is different. But whether the open economy dimension matters is a quantitative question, and in the literature which Gali surveys, the quantitative magnitude of this dimension is small. However, he also notes that this literature is still young, so I wondered if you had seen another paper which would suggest this difference is large.

      A back of the envelope approach: let's say (for argument) that the UK's output gap is zero, inflation is at target and the weighted average of the UK's trading partners output gaps is -3%, and that the natural real rate is 5% (the pre-crisis rate). To justify interest rates at the ZLB you need the coefficient on the foreign output gap to be >1 (!), which seems high given that 1 is normally on the upper end of coefficients we use on the domestic output gap.

      Of course, inflation is below target (for now), the output gap in the UK may be negative and the neutral/natural interest rate may be lower than 5%. But this back of the envelope calculation suggests that these arguments are likely to be more important than the foreign output gap, even if qualitatively the latter could matter a bit.

    3. I did not want to suggest that this factor explained all of the gap between current rates and the natural rate, which is partly why I mentioned sterling overvaluation. What I think is useful is to think in these broad terms, rather than just obsess about recent indicators.

  6. Re the first para above, I can’t see why a zero output gap is inconsistent with a 0.5% interest rate.

    As some MMTers are fond of pointing out, the state only needs to pay interest on a portion of the liabilities it issues if the amount of those liabilities are excessive, i.e. if the volume or amount of those liabilities is such that at a zero rate, demand would be excessive. In contrast, if the state issues just enough liabilities (i.e. base money) to induce the private sector to spend at a rate that brings full employment, there is no need for any interest to be paid on that money.

    1. Do MMTers think interest rates influence demand in any way?

    2. I'm damn sure they would, they'd agree that when you're bumping along the bottom, with investment still low, with inflation nowhere and pay rises low then raising rates is just about the worst signal you can send. I think they'd also say that it's a laggy, blunt instrument when you compare it to the fiscal toolbox available to a currency issuer.

    3. "Do MMTers think interest rates influence demand in any way?"
      It's hard to measure.
      "Mainstream analysis is almost entirely focused on the rate of interest (the price of borrowing money), and not the income flows associated with borrowing. Post-Keynesian analysis (in particular, Modern Monetary Theory) puts much more emphasis on the income flows from debt. Changing interest rates will change the income flows within the economy.

      If you want to pursue this angle, you will need to dig into the interest income flows within the flow of funds. The rate of interest has only a slow lagged effect on these flows, as a great deal of borrowing is done a fixed rate of interest, and the interest rate paid has been already locked in. For example, if you are looking at government interest expense, it will only move slowly as the average maturity of most developed government bond markets is at least 5 years or so. So long as the Treasury Bill segment of the curve can be locked down near the policy rate, the average interest cost on the portfolio of government debt will only move slowly, with a reversion time comparable to the average maturity of the debt."
      80% of new business in the mortgage market is Fixed Rate, and has been for quite some time now:

    4. Hello, I am a High School macro student, I have an assignment to publish a question on an economics blog and get a response from the author,
      My question is, Do you believe that any of these implications relate to the US in any way, or effect the US?

  7. I'm not an official spokesman for them, but I'd guess the answer is "yes". But my impression is they prefer something along the lines of peoples' QE, i.e. "print and spend" (an option which Keynes didn't object to).

  8. Why do positive output gaps in the rest of the world mean that the UK is selling less goods abroad?

  9. Why do positive output gaps in the rest of the world lead to the UK selling less goods abroad?


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time.